Hedge Fund Envy Comes to Buyout Shops

Providence Equity is the latest to form a trading group.
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Wall Street is given to identity crises, as evidenced by its latest trend: hedge fund launches by private equity groups.

After years of success doing leveraged buyouts, two of America's most prominent private equity teams recently announced plans to diversify into the rough-and-tumble world of hedge fund trading. Providence Equity emerged this week as the latest to make the jump, launching its own trading team that will take on the hedge fund strategy of distressed-debt trading.

The Rhode Island-based private equity group, which primarily focuses on media investments, will launch the new vehicle later this year, according to people close to the company. The fund will be named Newport Partners, and it will focus on distressed-debt trading, particularly among media companies. The company plans to raise up to $750 million and has hired a team from AIG to head the group.

A Providence Equity spokesman declined to comment on the plans.

The move comes as hedge fund managers and private equity funds fight a pitched battle for institutional assets. Providence's foray also counters an assault by hedge funds on private equity that has been going on for several years, the best-known example being Ed Lampert's work at Kmart and

Sears

(SHLD)

.

Lampert's original stake in Kmart was bought while the company was in bankruptcy and consisted of bonds. Indeed, so-called distressed debt is an area where both private equity and hedge fund players believe they have special expertise, so it's no coincidence that that is where Providence will begin. For a buyout shop, the sector provides a chance to exploit a talent for takeover negotiations and asset valuation.

"Take any of the go-go activity in the 1980s where people were buying investments and quickly flipping them," says Douglas Baird, professor of law at the University of Chicago. "Transfer that to the bankruptcy forum, and that's distressed debt."

Distressed-debt investing is often a way to "engage in a corporate takeover when the company is insolvent, by buying the debt," Baird says. If an investor gets in at the right level, the bonds convert into equity after the company emerges from Chapter 11. The bondholders then own a controlling equity stake.

Another titan of the industry, Kohlberg Kravis Roberts & Co., is also launching a hedge fund. The operation will be managed by

KKR Financial

(KFN)

, the publicly traded real estate investment trust, and will be named KKR Strategic Capital Fund. The fund will begin operations after the second quarter this year. According to a company statement, the fund will "primarily focus on stressed and distressed opportunities and market dislocation investments."

None of the activity should suggest that private equity, as an industry, is in trouble. Funds raised by buyout groups are at all-time highs, reaching about $86 billion in 2005, according to Thomson Financial. This year, the Wall Street theme remains privatization, and strategists expect another record year of buyouts in many industries, from chemicals to broadcasting.

But with the pool of alternative investment managers growing, private equity firms can't rest on their laurels. Debt trading at private equity companies offers two new ways for the groups to boost revenue.

"They can buy distressed debt and place bets that they know more about what the company is worth than the market knows as a whole," says Baird. "Or they buy a lot of the company's debt so they end up with control of the company later."

On a call Wednesday that discussed earnings results in KFN, KKR executives said that the new fund is an answer to demands from some of its large institutional clients and will position the buyout heavyweight to better compete for capital.

"Like every company, we need to continue to evolve to meet the marketplace changes, competitive dynamics and changing landscapes of our business. Increasingly scale is a critical feature to us in the lending and investment universe that we participate in," said Chief Executive Saturnino S. Fanlo. "Our core customer base, private equity firms and the large financial institutions, has grown massively in scale, and their perspectives have dramatically changed in the last 18 months, and we feel that we need to evolve with our customers."

That's a departure for an industry that has for years stuck to its knitting. The private equity strategy, made famous by KKR's leveraged buyout of RJR Nabisco in the late 1980s, continues to work well, with new acquisitions and lucrative cash-outs making headlines every day.

Perhaps it is another headline-grabbing tactic that is sowing the shift. Recently, hedge funds have managed to open up a new front in the battle for corporate influence with their focus on corporate activism. The move has often given hedge funds a more active role at the companies they buy into. The trend is perhaps best illustrated by Carl Icahn's activist lobby against

Time Warner

(TWX)

.

While this type of activity is more likely to use stock ownership as its vehicle, distressed-debt trading might eventually lead to similar inroads.